The last couple of weeks have proven to be quite interesting for bond markets around the world.
Major government debt markets including Germany, the U.S. and the U.K. have seen a dramatic sell-off, sparking stark jumps in bond yields. The sharp moves have left many analysts scratching their heads as to the causes, with the narrative now focusing on the possible return of inflation in the Eurozone and the U.S - a development that would erode the purchasing power of fixed payments on bonds. Still though, the swiftness of the resulting shift out of bonds has caught many analysts, economists and large investors by surprise given that just weeks ago people were paying through the nose to hoard government debt with extremely low yields.
German bunds have now seen their eighth day of losses, with the yield on the benchmark 10-year bund reaching 0.78 percent on Thursday, its highest level since December. Yields were hovering around zero less than two weeks ago. Barclays' Jim McCormick notes that moves of this size - in an asset famed for its stability and safeness - are extremely rare. They are also very painful for investors who have built their portfolios around a particular set of assumptions, such as that interest rates will remain low and volatility in the bond market subdued.
In the past 15 years, a rise in yields of this size has only happened twice – in mid-1999 and again in late-2011, as the ECB began to shore up bank funding issues in the midst of the eurozone crisis. Given that roughly less than 5% of participants in our last ... Survey expected bund yields above 50bp by the end of June (we are at 54bp today; nearly one third of the survey expected bund yields below zero), it is likely this bund rally has caused a great deal of dislocation for fixed income investors.
Here's a chart of the recent dramatic move in the German 10-year yield:
The yield on the UK's 10-year gilt is also hitting levels not seen since last year as it responds to global market moves as well as the U.K. general election.
Mark Holman, CEO of TwentyFour Asset Management, a fixed income specialist based in London, pointed out the perplexity of the recent market moves.
Here in the UK we are flirting close with 2% in 10 years, a level not seen since last November. These moves have taken place despite the softer data (particularly from the US) and despite the turmoil in Greece, which would usually trigger a safety haven flight to quality assets...The market knew that these ultra-low yields were just temporary, both here and in the US, and for a while they were rational. However the rationale for those ultra-low yields has gone for now and the market is readjusting. Where do they go to from here is hard to forecast. Our feeling is that they will not spiral all the time that central banks have specific inflation mandates, but the shorter term trend is higher and we do not want to stand in the way of that. Other areas of Fixed Income, such as credit spreads, are going to be more rewarding.
Here's a one year chart of U.K. 10-year yields.
And the same time frame for 10-year U.S. Treasury yields:
As HSBC's Steven Major notes - the sudden reversal of the trade - is nothing short of a classic pain trade:
The pain trade is a steeper curve, so given what happened in the past few weeks, this pain could have been excruciating. Our view has been that the risks of a steeper curve have been under-estimated by the market consensus and we believe the major rates curves have more potential to steepen between two- and 10-year maturities.
One month ago the consensus view was that curves could only flatten, driven by ‘more buyers than sellers’ in the Eurozone and the strong dollar containing inflation expectations for the US. It is generally recognised that negative rates in the Eurozone forced money up the local rate curves and down the credit spectrum, while encouraging a flow into higher yielding regions, including the US. But in the significant bear-steepening through late April and early May, we saw just how tired this view has become.